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Strategic Management Journal

Strat. Mgmt. J., 34: 10191041 (2013) Published online EarlyView 13 March 2013 in Wiley Online Library (wileyonlinelibrary.com) DOI: 10.1002/smj.2056 Received 10 May 2011 ; Final revision received 23 May 2012

MARKET FRICTIONS AS BUILDING BLOCKS OF AN ORGANIZATIONAL ECONOMICS APPROACH TO STRATEGIC MANAGEMENT


JOSEPH T. MAHONEY1* and LIHONG QIAN2
1

Department of Business Administration, College of Business, University of Illinois at Urbana-Champaign, Champaign, Illinois, U.S.A. 2 School of Business Administration, Portland State University, Portland, Oregon, U.S.A.

This paper shows that market frictions are fundamental building blocks for an organizational economics approach to strategic management. Various organizational economic approaches (transaction costs, property rights, real options, and resource-based) have distinctive focal problems and emphasize different combinations of market frictions. A wider recognition of the role of market frictions is useful for three main objectives. First, it helps identify an evolving market-frictions paradigm in strategic management. Second, it shows how two primary questions in strategy of why rms exist and why some rms outperform others and the three primary strategic goals of cost minimization, value creation, and value capture can be better joined and evaluated. Third, different combinations of market frictions can generate new research questions and advance theory development in the strategic management eld. Copyright 2013 John Wiley & Sons, Ltd.

INTRODUCTION
The purpose of this paper is to take stock and to look ahead concerning the role of market frictions as key building blocks of an organizational economics approach to strategic management. In terms of taking stock, this paper shows the logical cohesiveness, for at least the past quarter century, of the strategic management elds use and development of an organizational economics approach (Barney and Ouchi, 1986; Hesterly, Liebeskind, and Zenger, 1990; Rumelt, Schendel, and Teece, 1991) for addressing two primary questions: why
Keywords: market frictions; organizational economics; cost minimization; value creation; value capture
*Correspondence to: Joseph T. Mahoney, Caterpillar Chair of Business and Director of Graduate Studies, Department of Business Administration, College of Business, University of Illinois at Urbana-Champaign, 140C Wohlers Hall, 1206 South Sixth Street, Champaign, IL 61820, U.S.A. E-mail: josephm@illinois.edu

rms exist (the organizational boundary question1 ) and why some rms outperform others (as measured by economic rents2 ). Towards this objective, we develop a market-frictions logic that considers evolving paradigmatic contributions from transaction costs, property rights, real options, and the resource-based approach3 (Mahoney, 2005).
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The organizational boundary decision (Mosakowski, 1991; Parmigiani, 2007) includes (1) the existence of the rm (Coase, 1937), (2) the vertical integration of the rm (Williamson, 1975), and (3) the scope of the rm (Teece, 1980). 2 Economic rents refer to nancial returns that are in excess of the opportunity cost of capital, and can be derived from a sustainable competitive advantage. In this sense, the resourcebased economics approach (Montgomery and Wernerfelt, 1988) that focuses on economic rents is linked to the resource-based management approach that focuses on sustainable competitive advantage (Barney, 1991). 3 In the current paper, the term resource-based approach includes the resource-based view (Peteraf, 1993; Wernerfelt, 1984), the knowledge-based view (Grant 1996; Kogut and Zander, 1992), and the dynamic capabilities view (Eisenhardt and Martin, 2000; Teece, Pisano, and Shuen, 1997).

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and capabilities as the unit of analysis (Barney, 1991; Teece et al ., 1997). The discussion above reveals at least three points that motivate the current paper. First, each theory has its own canonical problem and specialized language, which may impose substantial difculties in developing a more fully developed paradigm in strategic management. We maintain, however, that there is a shared organizational economics logic that enables us to coherently tie various strands of the research literature into one cord. Specically, we seek to identify an evolving market-frictions logic, which can serve as a common language to facilitate better communication in the eld. Second, these distinct theories attend to different goals (Coff, 2010; Zajac and Olsen, 1993) by emphasizing one or more of the three primary strategic goals that we identied. For example, while transaction cost economics emphasizes the minimization of transaction costs, real options theory also considers the economic value-creation potential of a strategy (e.g., the growth options enabled by follow-on investments). As suggested above, cost minimization, value creation, and value capture are often intertwined in rm-level strategy, and a framework that simultaneously considers these three goals is not only likely to be more relevant for management practice but also to be more fruitful for richer theory development in strategic management (Brandenburger and Stuart, 2005; Chatain and Zemsky, 2011; Dyer and Singh, 1998; MacDonald and Ryall, 2004). Third, successful efforts have been made to join organizational economics theories such as (1) transaction cost economics and property rights theory (Foss and Foss, 2005; Kim and Mahoney, 2005), (2) property rights theory and the resource-based approach (Kim and Mahoney, 2002; Miller and Shamsie, 1996), (3) the resource-based approach and transaction cost economics (Argyres, 1996; Madhok, 2002), and (4) transaction cost economics and real options theory (Folta, 1998; Leiblein and Miller, 2003). The pairwise joining of these theories suggests the presence of logical coherence, but does not fully reveal the fundamental commonalities among all these theories. We intend to extend this line of effort by seeking to identify such fundamental commonalities. We suggest that greater paradigmatic theory development can be achieved by focusing on
Strat. Mgmt. J., 34: 10191041 (2013) DOI: 10.1002/smj

Underpinning these two primary questions are three distinct yet interrelated strategic goals: cost minimization, value creation, and value capture.4 The interrelationship among these different strategic goals can be complements or substitutes. On the one hand, cost minimization directly contributes to value creation and can contribute to economic rents. Further, value creation and value capture are complementary when an expectation of value appropriation leads decision makers to carry out value-creating strategies under uncertainty. On the other hand, a single-minded pursuit to capture value can lead to lower value creation. Managerial practice must consider simultaneously the goals of cost minimization, value creation, and value capture of a specic strategic choice. Theory development in strategic management has yet to fully synthesize this managerial challenge, however, although all of the necessary building blocks seem to be in place. Specically, transaction costs theory regards the transaction as the unit of analysis to examine better ways to achieve the objective of (production and transaction) cost minimization through organizational boundary choices (e.g., make-or-buy decisions) and governance structure designs (e.g., line of authority and incentive systems) (Kor, 2006; Williamson, 1996). Property rights theory emphasizes value appropriation through ownership via residual claimancy and residual control rights (Alchian and Demsetz, 1972; Grossman and Hart, 1986), as well as the implications of propertyrights partitioning for the economic value creation of resources (Jensen and Meckling, 1976; Kim and Mahoney, 2005). Real options theory includes interproject and intertemporal dimensions to organizational boundary decisions and economic value creation (Kogut, 1991; McGrath and Nerkar, 2004). The resource-based approach (Helfat and Peteraf, 2003; Penrose, 1959) emphasizes the continuing search for economic rents and sustainable competitive advantage, as well as individual skills and organizational routines (Nelson and Winter, 1982; Winter, 2003), using the bundle of resources
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Following the formula for maximizing NPV, we consider cost minimization a subset of economic value creation, which is achieved by (1) increasing revenues, (2) reducing costs, and/or (3) reducing risk in ways that cannot be replicated by shareholders. We separate discussion of cost minimization from value creation to distinguish the different focuses of different organizational economics theories on their focal problems.

Copyright 2013 John Wiley & Sons, Ltd.

Market Frictions as Building Blocks


market frictions5 as the key unit of analysis. We rst develop a more complete organizational economics framework by identifying the concept of market frictions as the common building blocks of these different theoretical lenses, through systematic use of the premises of the rst fundamental welfare theorem of economics (Arrow and Hahn, 1970; Debreu, 1959). We further suggest that the focus of combining theories per se can be limiting, since it can predetermine a cluster of market frictions associated with each organizational economics theory. Moving from the molecular level of theories as clusters of market frictions to the atomistic level of the market frictions themselves as the unit of analysis will remove strategy theorists constraints for developing new theory. Focusing on market frictions as fundamental building blocks provides an unconstrained choice of various new combinations of market frictions. We further look ahead and show that the market-frictions logic can help structure the organizational economics literature to enable recognition of paradigmatic themes and to generate new research questions. The next section develops the market-friction logic and discusses its role in the development of various organizational economics theories. The third section proposes a framework for further paradigmatic theory development through joining market frictions underpinning cost minimization, value creation, and value capture, and illustrates how explanations and predictions of strategic phenomena can be achieved by using this framework. The last section provides conclusions.

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are neither interrm externalities nor interproject and intertemporal spillovers), perfect information, and complete markets (Debreu, 1959). Under this theorem, rms are expected to earn zero economic rents in long-run competitive equilibrium (Cyert, Kumar, and Williams, 1993). However, as the strategy eld emphasizes,6 the business world is fraught with market frictions, such as asymmetric and imperfect information (Holmstr om, 1979; Phlips, 1988), uncertainty coupled with opportunism (Akerlof, 1970; Arrow, 1974), nonfungible resources due to sunk costs and asset specicity (Baumol, Panzar, and Willig, 1982; Nickerson and Silverman, 2003), economies of scale and indivisibilities (Chandler, 1990; Scarf, 1994), demand synergies and supply-side economies of scope (Penrose, 1959; Teece, 1980), externalities (Coase, 1960; Greenwald and Stiglitz, 1986) coupled with positive transaction costs (Coase, 1937; Williamson, 1975), and poorly or undened property rights (Barzel, 1982; Demsetz, 1967). Table 1 shows how the various theoretical lenses of the organizational economics approach in strategic management systematically relax one (or more) of the assumptions of the rst fundamental welfare theorem of economics.7 The economic consequences of a particular combination of market frictions may vary in degree, from relatively low to severe: market imperfection, market inefciency, and market failure. In this paper, a market imperfection refers to when the price signal does not lead to Pareto optimality in which resources are allocated efciently
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TAKING STOCK: A MARKET-FRICTIONS LOGIC


The rst fundamental welfare theorem of economics demonstrates that a competitive equilibrium leads to an efcient allocation of resources (Arrow and Hahn, 1970). Assumptions contained in this theorem include independence in consumption and in production (e.g., there
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In this paper, the fundamental concept of market frictions is dened similarly to Arrows (1969) description of the concept of transaction costs. Market frictions, in general, impede market efciency and in particular cases may completely block the formation of markets (e.g., Akerlof, 1970). Thus, the concept of market frictions (like the concept of transaction costs) is a broad category for capturing the costs of running the economic system (Arrow, 1969: 48).

The glue that holds the Ricardian, Coasean, and Penrosean approaches together is the construct of market frictions. While beyond the scope of the current paper, it is highly warranted to consider market frictions as not only a unifying concept within the strategic management eld and within the Strategic Management Journal , but also across the Strategic Entrepreneurship Journal and Global Strategy Journal . For example, historical and contemporary entrepreneurship literature views entrepreneurship as alertness to price differentials due to market frictions (Delmar, Wennberg, and Hellerstedt, 2011; Kirzner, 1979). In terms of the international business and global strategy literature, the theory of foreign direct investment posits that, in general, market frictions in capital, nal goods, or strategic factor markets across countries create opportunities for the rm in one country to benet by existing in another country (Caves, 1982; Hennart, 2011; Kumar, 2009; Seth, Song, and Pettit, 2002). 7 In order for the rabbit to be pulled out of the hat, the rabbit must be placed in the hat. In other words, for any paper to make an economic argument (mathematical or verbal) for why the rm exists or why rm-level rents are realized, the rst fundamental welfare theorem of economics demonstrates that the paper must posit at least one market friction.
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Table 1.

J. T. Mahoney and L. Qian


Assumptions about market perfection and market frictions Organizational economics in strategic management Imperfect and asymmetric information (Holmstr om, 1979) Uncertainty and incomplete markets (Arrow, 1974) Market power (Caves and Porter, 1977) Asset specicity (Williamson, 1985) Indivisibilities and increasing returns to scale (Scarf, 1994) Economies of scope (Teece, 1980) Spillovers and externalities with positive transactions costs (Coase, 1960; Katz and Shapiro, 1985) Positive transaction costs (Coase, 1937) Poorly or undened property rights (North, 1990)

First fundamental welfare theorem Perfect information Complete markets Perfect fungibility of assets (i.e., no asset specicity) Constant returns to scale Independence in consumption and production Zero transactions costs Perfectly dened property rights

(Arrow and Hahn, 1970). Market inefciency occurs when nonprice governance, such as hierarchy and/or government, allocates resources more efciently than the market. Williamson (1985) emphasizes that a pragmatic evaluation of efciency (i.e., transaction cost minimization) requires a comparative assessment of imperfect governance alternatives, among which each discrete structural alternative (Williamson, 1991a) has its corresponding combination of market frictions. Market failure refers to where a market is incomplete or may even collapse (Akerlof, 1970). Figure 1 represents these logical relationships.8 Strategic management seeks remedies for these various economic consequences due to market
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frictions for the purpose of cost minimization, or ways to leverage these market frictions for the purpose of value creation and value capture (Mahoney, 2001; Yao, 1988). To show that market frictions are fundamental building blocks for various organizational economics theories in strategic management, we take stock of the research literature by highlighting how each theoretical lens has utilized a combination of market frictions to address the strategic goals of cost minimization, value creation, or value capture. Organizational economics approach to cost minimization Transaction costs theory is the primary organizational economics approach to the strategic goal of cost minimization, focusing on the comparative efciency of alternative governance structures in reducing transaction costs. Primary market frictions emphasized in transaction costs theory include opportunism, asset specicity, and uncertainty (Williamson, 1985).9 Opportunism and asset specicity The potential for opportunism by one of the exchange partners poses transactional hazards to the other partners, especially those incurring substantial transaction-specic investments (Hoetker and Mellewigt, 2009). Internalization can attenuate
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We note here the relationship among these three concepts and the overarching concept of market friction. Consider a buyer who values an item at $50, and a current owner of that item who values it at $48. In this case, a Pareto-improving trade ideally would take place to make both this buyer and seller better off (Coase, 1960). Market frictions are the transaction costs of running the economic system (Arrow, 1969). If the costs of exchange for this item in terms of searching, negotiating, and enforcing an agreement (Coase, 1937) exceed $2, then these transaction costs drive a wedge between the buyers valuation and sellers valuation, and thus the trade will not take place. Therefore, market frictions at the most general level are those costs that impede a Pareto optimal allocation of resources (Arrow and Hahn, 1970). Using the three terms of the current paper, the concept of market frictions relating to: (1) market imperfection is considered by Arrow and Hahn (1970), (2) the more severe market inefciency is considered by Williamson (1975), and (3) the most severe result of market failure is considered by Akerlof (1970). We further note that the phrase market frictions has been used in the extant research literature to refer not only to the consequences of market imperfection, market inefciency, and market failure, but also to the characteristics of market exchanges that may lead to these consequences. The remainder of this paper uses the term market frictions to refer to the characteristics of market exchanges, and the terms market imperfection, market inefciency, and market failure to refer to the consequences of market frictions.

Analogous transaction-cost-related problems can also arise within rms after internalizationthat is, that inclusion within the rms boundary does not eliminate those sorts of problems (Miller, 1992). The key idea is to conduct a comparative assessment of imperfect governance alternatives (Williamson, 1985).
Strat. Mgmt. J., 34: 10191041 (2013) DOI: 10.1002/smj

Copyright 2013 John Wiley & Sons, Ltd.

Market Frictions as Building Blocks


Consequences of market frictions Market frictions 1. Asymmetric and imperfect information 2. Uncertainty and opportunism 3. Sunk costs and asset specificity 4. Economies of scale and indivisibilities 5. Demand synergies and economies of scope; 6. Externalities (inter-temporal and inter-project spillovers) and positive transaction costs; 7. Poorly- or Un-defined property rights

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Market imperfection: Not Pareto optimal, but comparatively still the best of all feasible alternatives (e.g., Arrow and Hahn, 1970). Market inefficiency: Hierarchy replaces price systems to minimize positive transaction costs (e.g., Williamson, 1975). Market failure: Incomplete market or the market completely collapses (e.g., Akerlof, 1970).

Figure 1.

Factors/consequences of market frictions

the likelihood of an exchange partner acting opportunistically by posing economic hold-up problems for other partners (Klein, Crawford, and Alchian, 1978). The research literature largely corroborates the prediction that higher transaction costs due to opportunism and asset specicity result in higher economic safeguards such as internalization to mitigate contractual hazards, and thereby minimize cost (Lajili, Madunic, and Mahoney, 2007; Oxley, 1997; Shelanski and Klein, 1995).

extent and sustainability of economic rents, as well as the values of real options. Extent of economic rents (1) Relevant/valuable: A resource is relevant/valuable if there is demand for it, when it enables a rm to conceive of, or implement, strategies that improve the rms efciency or effectiveness (Barney, 1991). Peteraf and Barney (2003) dene the economic value of a resource as the perceived benets from a resource above its economic costs. Resource-based logic suggests that obtaining such a valuable resource can occur through luck and/or asymmetric information (Barney, 1986). (2) Scarcity/rare: Resources are rare if supply is limited, and expansion in supply cannot be easily achieved. Further, resources may be scarcer for those rms that have less access to those resources. Peteraf (1993) maintains that the possession of superior resources by some rms in an industry can result from asymmetric information about the economic value of those resources when rms initially developed them. Another form of resource scarcity is uniqueness of resources, for example, resources that are created by a rm and henceforth are specic to that rm. Imperfect information concerning availability of resources or the way to create resources can reinforce their scarcity. (3) Heterogeneity: Where does such heterogeneity come from (Leiblein and Madsen, 2009; Nelson, 1991)? Our response to this question is the existence of market frictions, the key being asymmetric information about resource attributes and availability. Further, when considering stock-and-ow dynamics (Dierickx and Cool, 1989), information asymmetry combined with heterogeneity in a resource stock formed at time t inuences rms
Strat. Mgmt. J., 34: 10191041 (2013) DOI: 10.1002/smj

Organizational economics approach to value creation The resource-based approach considers the strategic goal of value creation and, more specically, the potential economic rents derived from heterogeneous resources and capabilities. Barney (1991) suggests that a continuing search for sources of sustainable competitive advantage focuses on resources that are in demand (i.e., valuable), rare, inimitable, and nonsubstitutable (i.e., the VRIN criteria), which constitute necessary conditions for value creation and economic rents. Relatedly, Peteraf (1993) develops the four cornerstones of competitive advantage: superior resources; the ex post limits to competition; imperfect resource mobility; and the ex ante limits to competition. The real options theory provides a theoretical explanation for why rms may make investment decisions that differ from what the net present value (NPV) approach would prescribe, and proposes that, under certain conditions, real options value will comprise a substantial portion of the economic value of projects, lines of business, and rms (Dixit and Pindyck, 1994; Trigeorgis, 1996). Below we show that market frictions are an important basis for value creation, and underpin the
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inimitability. Barney (1991) attributes such inimitability to path dependence (Arthur, 1989), social complexity (Blyler and Coff, 2003), and causal ambiguity (Lippman and Rumelt, 1982), which can be derived from market frictions of interrm externalities, intrarm spillovers, and asymmetric information. (3) Nonsubstitutability: Substitutability or nonsubstitutability is a relative term, since for any resource there can be another resource that can at least partially substitute for the focal one, either cross-sectionally or longitudinally (Dierickx and Cool, 1989). Thus, there is often imperfect substitutability between rm resources. Value creation through real options The real options theory holds that in a context characterized by high uncertainty and managerial discretion, managerial exibility to adjust a predetermined course of action upon arrival of new information is economically valuable, and investments that enhance exibility will add economic value to option holders (Dixit and Pindyck, 1994; Trigeorgis, 1996). Real options theory considers various common real options (e.g., the option to defer, to abandon, and to grow), and has been used to examine various strategic phenomena (e.g., investment decisions, organization and governance decisions, and rm valuations) (Li, James, Madhavan, and Mahoney, 2007). Key market frictions emphasized in real options theory include uncertainty in investment decisions, the (in)exibility in strategic choice, and the interproject as well as intertemporal spillovers (Bowman and Hurry, 1993; Kogut, 1991; McGrath and Nerkar, 2004). The real options lens attempts to account for these spillover effects within the constructs of real options to defer, abandon, or grow (Dixit and Pindyck, 1994), which can create value by generating future decision rights (McGrath, Ferrier, and Mendelow, 2004). The real options perspective is a fundamental contribution to strategic management because it contributes to designing operational solutions to market frictions (e.g., dealing with spillover effects that would otherwise be improperly priced) for the purpose of value creation and value capture. Specically, calculating the option value to defer addresses the market friction of uncertainty in investment decisions, calculating the abandonment option addresses the market friction of the level
Strat. Mgmt. J., 34: 10191041 (2013) DOI: 10.1002/smj

future strategies in resource procurement, deployment, and divesture, and over time, heterogeneity across rms will increase. Thus, the presence of rm-level heterogeneity implies the presence of various market frictions, like causal ambiguity and asset specicity/uniqueness (Lippman and Rumelt, 1982; Mahoney and Pandian, 1992). (4) Complementarity: Amit and Schoemaker (1993) consider complementarity as a relationship between resources where the relative magnitude of the strategic value of one resource may increase with an increase in the relative magnitude of other resources (see also Milgrom and Roberts, 1990; Teece, 1986). Complementarity can occur through positive interproject spillovers, such as economies of scope (Teece, 1980), and through positive intertemporal spillovers, such as asset accumulation or interconnectedness over time (Dierickx and Cool, 1989). This resource complementarity can reinforce the difculty in transfer, imitation, or substitution of any single resource (Parmigiani and Mitchell, 2009), and thus can enhance the extent of potential value creation from the resource. Sustainability of economic rents Impediments to economic activities (Yao, 1988) or market frictions are especially relevant to sustainability of economic rents. Important concepts here include: low transferability, inimitability, and nonsubstitutability, which are each considered in turn. (1) Low transferability: Imperfect resource mobility can result from nontradable or cospecialized assets. A resource may be nontradable because of (i) difculties in pricing the resource due to information asymmetry between sellers and buyers (e.g., brand image) (Shamsie, 2003); (ii) impediments in transferring due to tacitness and intangibility (e.g., R&D capabilities) (Itami and Roehl, 1987); (iii) difculties in partitioning (e.g., team-embodied skills) (Williamson, Wachter, and Harris, 1975); and (iv) isolating mechanisms such as patent and trademark enforcement (Rumelt, 1984). Moreover, even if a resource is tradable, the potential economic rents from this resource will be attenuated if it is separated from its cospecialized asset(s) (Teece, 1986). (2) Inimitability: The key concept of inimitability is intrinsically related to low transferability, to the extent that some causes of low transferability such as nontradable or cospecialized resources can lead to
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Market Frictions as Building Blocks


of (in)exibility in strategic choice, and calculating growth options addresses interproject and intertemporal spillovers in the presence of market frictions. Organizational economics approach to value capture The resource-based approach also considers value capture. Grant (1991) traces the prot-earning potential of a resource to the extent and sustainability of the competitive advantage established, and the rms ability to appropriate the economic rents generated. Amit and Schoemaker (1993) consider scarcity, complementarity, and appropriability to be important characteristics of these resources and capabilities that are posited to generate rm-level rents. Appropriation of economic rents emphasized in the resource-based approach Appropriation of economic rents is a necessary condition for economic value sustainability (Coff, 2010). Low appropriability lowers the incentives to invest in resources, activities, and dynamic capabilities in the value-creation process. The appropriability of economic rents is inuenced by complementarity, property rights, and embeddedness, which we discuss in turn. (1) Complementarity: If a rm possesses a cospecialized resource (Teece, 1986), then there is idiosyncratic bilateral synergy (Mahoney and Pandian, 1992: 368) in which each rm possessing a cospecialized resource is expected to appropriate some of the gains from the joined resources. Further, if one of the resources in the combination is held by a rm in a competitive factor market while the other rm possesses a valuable, rare (unique), inimitable, and nonsubstitutable resource, then the rm possessing such a unique resource will appropriate the entire economic value created in this resource combination (Barney, 1986). We emphasize that the market frictions, which result from asset specicity, not only help explain why these cospecialized resources are owned by one rm (Teece, 1986) but also why cospecialized resources can lead to economic value creation (Mahoney, 2001). (2) Embeddedness: The concept of embeddedness involves both crosssectional and longitudinal interconnectedness of resources (Dierickx and Cool, 1989). Consider the example of a professor of chemistry who is tied to
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a university-owned research lab relative to a business school professor who has relatively fewer ties to the physical resources. The embeddedness logic suggests that ownership of the physical asset leads to de facto control over human resources (Grant, 1991; Hart, 1995). In particular, the owner of a physical resource (i.e., the university) is typically in the position to appropriate more of the value creation by the chemistry professor than the relatively more mobile professor of business.

Value capture emphasized in property rights theory Well-dened property rights regimes (e.g., patent and trademark protection, and equity-share arrangements) provide direct mechanisms for economic appropriability (Barzel, 1989; Eggertsson, 1990). In contrast, poorly or undened property rights are key sources of market frictions that create misleading price signals and thus reduce efciency in resource allocations (Coase, 1960). Assignment of residual claimancy (Alchian and Demsetz, 1972) and residual rights of control (Grossman and Hart, 1986) are important components of organization design. 10 For example, Grossman and Hart (1986) show that imperfections in residual control assignments (e.g., the contractual party having the greatest potential for increasing aggregate gains is not assigned residual control rights) can lead to poor resource allocation. In particular, if the contractual party contemplating rm-specic investment ex ante is not afforded residual control rights ex post, then a farsighted decision maker will foresee the contractual hazards of potentially having at least part of their investment appropriated, and thus there will likely be a rational underinvestment in rm-specic capabilities (Wang and Barney, 2006; Wang, He, and Mahoney, 2009).

10 Williamson notes that whereas transaction-cost economics locates the main analytical action in the ex post implementation stage of contract (where inefciencies due to maladaptation arise), Grossman-Hart-Moore (Grossman and Hart, 1986; Hart and Moore, 1990) assume away ex post maladaptation (by invoking common knowledge of payoffs and costless bargaining), thereby to focus instead on how different congurations of physical asset ownership (to which residual rights of control accrue) are responsible for efciency differences at the ex ante stage of contract (2002: 442).

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based on market frictions underpinning these various organizational economics theories. Building on the same fundamental logic, each theory branches out by emphasizing different but overlapping combinations of market frictions to address its canonical problem. By decomposing each organizational economics theory to a combination of different market frictions, we can now identify those frictions that are either neglected or seldom examined within a particular theory.11 By considering theory integration as a recombination of a subset of the underpinning market frictions, we can move towards the development of a paradigmatic market-frictions framework.

What is the common language?A synthesis of market-frictions logic By illustrating how the various organizational economics approaches to the three strategic goalscost minimization, value creation, and value appropriationhave been developed in the strategic management eld, the preceding discussion suggests the following ideas. First, underpinning the three strategic goals are various market frictions. These market frictions interact to create the need for cost minimization, or the opportunity for value creation and value capture. A rm can choose its organizational boundary and governance design to minimize costs and to capture value. It can also develop resources and capabilities that enable value creation and value capture (Adner and Zemsky, 2006; Chatain, 2011). Second, each organizational economics theory is derived from a particular subset of the full menu of market frictions. For example, asset specicity, asymmetric information, and uncertainty are the primary market frictions emphasized in transaction costs theory, and externalities in the presence of market frictions (Coase, 1960) are emphasized in property rights theory. Third, although distinct theories emphasize different combinations of market frictions, these combinations are also overlapping as some key market frictions are commonly emphasized, such as asymmetric information. Fourth, these theories may share very similar concepts, albeit with different terminology. For example, the concept of high asset specicity emphasized in transactions costs theory, the concept of high-level commitment emphasized in the resource-based approach, and the concept of low abandonment option (i.e., high sunk costs) emphasized in the real options theory are all derived from one fundamental construct, that is, the nonredeployability of assets. While the rst fundamental welfare theorem of economics assumes the perfect fungibility of assets, the various organizational economics theories relax this key assumption. We use Table 2 as an illustration of the prevailing utilization of market frictions in the strategic management literature. Column 1 provides the primary market frictions and the related behavioral assumptions. Column 2 includes constructs derived from these market frictions. Columns 36 provide representative studies that utilize these corresponding constructs. Table 2 indicates a coherent logic
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LOOKING AHEAD: FROM MOLECULES TO ATOMS


Having shown that many of the extant research studies in strategic management can be logically reconstructed as some combination of market frictions, we show in this section that it can be more effective to view paradigmatic theory development not simply as a process of joining multiple organizational economics theories per se, but as integrating multiple market frictions that underpin each theory and the three strategic goals. 12 Lets rst consider recent developments in the organizational economics approach to strategic management, which has started to take an integrative approach, to the extent that multiple strategic goals are examined concurrently, and from multiple theoretical perspectives. We show that these recent theoretical developments can also usefully be characterized as new combinations of market frictions that yield new strategic insights.

11 It should be noted that within Table 2, the construction of the organizational economics approach in strategic management has been viewed in terms of existing organizational economics theories (reading Table 2 vertically). This paper suggests that the generation of new theory by the next generation of strategic management scholars can be facilitated if we reconstruct the extant research literature by viewing Table 2 horizontally, and make the construct of market frictions the essential building block and fundamental unit of analysis. Table 3 illustrates this reconstructed logic. 12 While lling gaps in theories is one approach to moving the strategic management eld forward, the current paper also suggests an alternative approach: No commitment to any one organizational economics theory is required. What is involved, rather, is the selection of market frictions best suited to deal with the management problem at hand.

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Table 2. Transaction costs theory Dyer (1997) Singh and Kundu (2002) Arora and Merges (2004) Pisano (1990) Norton (1988) Hennart (1993) Jones (1983) Grossman and Hart (1980) Gulati (1995) Foss and Foss (2005) Anton and Yao (2002) Li (2008) McGrath (1997) Folta and Miller (2002) Kogut and Kulatilaka (2001) Folta (1998) Brush and Artz (1999) Szulanski (1996) Property rights theory Real options theory

Market frictions emphasized by various theories in organizational economics Resource-based approach

Market frictions

Derived constructs

Asymmetric information

Environmental uncertainty Tacit knowledge Tan and Mahoney (2006) Balakrishnan and Wernerfelt (1986)

Uncertainty

Technological uncertainty

Copyright 2013 John Wiley & Sons, Ltd.

Demand uncertainty

Complexity Ouchi (1980) Hill (1990) Chiles and McMackin (1996) Balakrishnan and Koza (1993) Chi (1994) Klein et al . (1978)

Task programmability

Walker and Weber (1984) Mahoney (1992)

OBrien, Folta, and Johnson (2003) Leiblein (2003)

Opportunism

Social programmability Opportunistic behavior Trust/relational experience Ex ante adverse selection Ex post moral hazard

Song and Montoya-Weiss (2001) Kor, Mahoney, and Watson (2008) Nickerson and Zenger (2004) Barney and Hansen (1994) Mahoney (2001) Verona and Ravasi (2003) Kim and Mahoney (2006) Foss and Foss (2005)

Ex post hold-up

Asset specicity

Asset specicity

Coff and Laverty (2007) Folta and Miller (2002) Chi and McGuire (1996) Leiblein and Miller (2003) Sanchez (2003) Cuervo-Cazurra and Un (2010) Kumar (2005)

Wang and Barney (2006) Yeoh and Roth (1999) Dyer (1996) Helfat (1997)

Asset cospecialization

Poppo and Zenger (1998) Santoro and McGill (2005) Teece (1986) Arrow and Hahn (1970) Teece (1980) Hennart (1988) Mayer and Salomon (2006) Williamson ( 1991b)

Hart and Moore (1990) Rajan and Zingales (1998) Pitelis and Teece (2010) Liebeskind (1996) Henderson and Cockburn (1996) Liebeskind (1996) Coase (1960) Zhao (2006) Ostrom (1990)

Production economies

Asset complementarity Economies of scale

Kogut (1983)

Economies of scope

Interrm externalities

Public goods

Vassolo, Anand, and Folta (2004) McGrath (1999)

Market Frictions as Building Blocks

Intrarm spillovers

Knowledge spillover

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Poorly/un dened property rights

Property rights regime

Kang, Mahoney, and Tan (2009) Reuer and Tong (2005)

Lieberman and Montgomery (1988) Helfat and Eisenhardt (2004) Kim and Mahoney (2002) Blyler and Coff (2003) Miller and Shamsie (1996)

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scale/scope (Teece, 1982). Williamson (1975: 8384) and Teece (1980) emphasize that technological interdependency or economies of scope, per se, only explain the colocation of resources. It does not, by itself, explain or predict the organizational boundary decision, which is determined by the extent of market frictions. Therefore, more rened theory building makes clear that when economies of scope or technical complementarity are combined with intrarm spillovers and market frictions, the decision of internalization may be needed to achieve more fully the benets of production economies relative to markets. The dual role of value creation and cost minimization of a certain governance choice is emphasized here. (b) Cost minimization coupled with value capture The property rights theory informs not only the determination of economic value creation, but also enables analysis of value distribution or the strategic goal of value capture (Kim and Mahoney, 2010). Property rights theory suggests the importance of well-dened residual claimancy and residual control rights, which can be either incentives or disincentives for rm-specic investment, and act as conduits upon which economic value of resources can be channeled to high yield uses (Mahoney, 2005; Milgrom and Roberts, 1992). In general, externalities when combined with positive transaction costs have been a concern in the property rights literature (Coase, 1960; North, 1990). The current paper also focuses on a context in which market frictions are likely to be critical, namely, when there is high asset specicity (Grossman and Hart, 1986; Williamson, 1985). Asset specicity and negative interrm externalities : As an example, Kim and Mahoney (2002) examine oil eld unitization to explicate the effects of investments characterized by high levels of asset specicity, ill-dened property rights, and externalities with positive transaction costs. In particular, the negative externalities of oil migration towards those oil rms that drill early typically led to overdrilling at poor location choices. Thus, a substantially suboptimal aggregate amount of oil extraction was experienced for decades in Oklahoma and Texas (Libecap, 1989). The
Strat. Mgmt. J., 34: 10191041 (2013) DOI: 10.1002/smj

Recent developments in organizational economics approach

(a) Cost minimization coupled with value creation. Later development in the transaction costs theory literaturelargely originating from the strategic management eldhas started to incorporate the strategic goal of value creation, pointing to the dual role of governance structure for both cost minimization and value creation (e.g., also including revenue drivers), as well as the interaction between the goals of cost minimization and value creation (Zajac and Olsen, 1993). These new developments are, however, still derived from the fundamental market frictions, only now with new combinations of market frictions. Intrarm spillovers and governance inseparability : Argyres and Liebeskind (1999) provide a time dimension to transaction cost economics to explain rm boundary choice dynamically. In particular, this line of reasoning maintains that governance choices, such as previous contractual commitments entailing sunk costs (asset specicity), may enable or constrain a rms subsequent governance choices (Aggarwal and Hsu, 2009). This economic logic resonates with the extant research literature on dynamic transaction costs theory (Langlois, 1992). An example for positive spillovers occurs when there is learning-by-doing derived from contracting experience, and thus the decision to contract today may positively inuence subsequent contracting capabilities (Mayer and Argyres, 2004). An example of negative intrarm spillovers would be if internal procurement, internal expansion, and program persistence biases exist in the vertically integrated rm (Williamson, 1975: 118124), and therefore these internal organizational distortions that could potentially constrain future governance choices should be included in the decision calculus at the outset. Potential value creation embedded within a certain governance choice is emphasized in this context. Intrarm spillovers and economies of scale/scope : Spillovers can occur with production capabilities that entail economies of
Copyright 2013 John Wiley & Sons, Ltd.

Market Frictions as Building Blocks


lack of oil eld unitization for migratory oil, or the difculty in establishing property rights to specic assets, negatively impacts productive utilization of these assets. Further, Kim and Mahoney (2002) show in the context of oil eld unitization that asymmetric information about location-specic assets can impede value creation as it stymies mutually benecial trade (Coase, 1960). Also, in terms of value capture, Libecap (1989) shows that distribution conicts can lead to decision makers actively blocking changes in property rights that would otherwise lead to efciencies. Asset specicity and loss of positive intrarm spillovers : As Coase (1960) shows, the initial assignments of property rights facilitate subsequent trade. If property rights are undened, markets may completely break down (North, 1990). Further, if initial property rights are poorly dened, the market-friction consequences can still be quite substantial (Miller and Shamsie, 1996). The same problem that may occur due to market frictions in interrm exchange involving asset specicity and externalities (Libecap, 1989) can occur with intrarm exchange involving asset specicity and spillovers effects (Kang et al ., 2009). For example, while a strategic outsourcing of employees may maximize the economic returns for a particular division of a company, the benets that these employees provided in consultation with people in other divisions of the same company may be lost, in which case the economic returns to the enterprise can be negative. (c) Value creation coupled with value capture Poorly or undened property rights and capabilities with value creation potential : Consider a multidivisional rm with highly related business units where residual income to managers is based only on divisional return on assets. Such property rights within this rm are poorly dened since the managers of these highly related businesses are unlikely to share information in this compensation system. With a lack of knowledge transfer, the realized capabilities of such a rm will be far from its potential capabilities. A change in the property rights regime of the rm, where divisional managers are rewarded
Copyright 2013 John Wiley & Sons, Ltd.

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based on corporate ROE, for example, would likely improve information sharing in the rm due to improved incentive alignment, and thereby facilitate greater capability development. Thus, property rights and dynamic capabilities are tightly linked (Ghemawat, 1991). Asset specicity and positive intrarm spillovers : one example of a substantial positive intrarm spillover is R&D, in which knowledge creation may have positive spillover applications to other divisions in the company (Argyres and Silverman, 2004; Helfat, 1997). However, due to potential multidivisional negotiating problems involving investments with high levels of asset specicity, these potential positive spillovers may not be fully realized. In other words, the marginal benets of R&D investment for a particular division may be smaller than the marginal costs for that division, in which case the investment might not occur despite the fact that the net impact of the R&D investment at the rm level would be positive when the full costs and benets are accounted for. The discussion above reinforces the importance of a paradigmatic market-frictions framework for the strategic management literature. It shows the necessity to develop a framework that can more completely analyze the three intertwined strategic goals. Considering more than one strategic goal has already enabled greater theory development, which offers more explanatory and predictive power for various strategic phenomena. Further, it shows that a paradigmatic framework has been emerging within the strategy eld in which the various market frictions are the fundamental building blocks. This paper maintains that more self-conscious intention by scholars within the strategy eld to continue in this direction is likely to be fruitful for both strategic management theory and practice. Extending beyond the two primary questions: a generalized market-frictions approach As Table 2 suggests, each market friction has been, or can potentially be, incorporated into each organizational economics lens. Focusing on the concept of market friction as the key unit
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reward of a nominal share of the teams output. Blair and Stout (1999) thus explain that the role of a board of directors in public corporations is not simply to reduce agency costs, as most principalagent model proponents would suggest, but to also encourage rm-specic investment essential to certain forms of team production by all members of a corporation, including managers, employees, and other key stakeholders. Team members of a corporation voluntarily relinquish important control rights over rm-specic inputs and outputs to an independent board of directors and address contracting problems inherent in team production via a mediating hierarchy (Blair and Stout, 1999). With high rm-specic human capital, shareholders might welcome labor representation on the board of directors (Osterloh and Frey, 2006). This detailed example shows the fruitfulness of theory development obtained by joining new combinations of market frictionswhich is a key message of the current paper. In particular, joining two different market frictions, asset specicity and the nonseparability problem in team production, Rajan and Zingales (1998) provide a novel explanation of one source of power in the rm, that is, the restricted access to critical assets, which further offers rich insights for both strategic management theory and for management practice. Blair and Stout (1999) extend the theory by applying Rajan and Zingales (1998) novel explanation to the role of the board of directors in the law of the public corporation. A second example to show the fruitful theory building through consideration of numerous market frictions is Chi (1994) from the Strategic Management Journal . Chi (1994) uses multiple market frictions that cut across the boundaries of several organizational economics theories, including asymmetric information that leads to potential adverse selection and moral hazard problems, asset specicity that resides in complementarities of strategic resources from two rms, the economic hold-up problem that may arise in trading such strategic resources, resource inimitability and immobility that characterize those strategic resources, and property rights assignment regarding residual claimancy and residual control rights. By integrating these various market frictions, Chi studies the transactional problems in trading strategic resources between two rms, the antecedents of these problems, and the remedying mechanisms for these problems. By developing a
Strat. Mgmt. J., 34: 10191041 (2013) DOI: 10.1002/smj

of analysis may prove useful in explaining the two primary questions in the strategy eldwhy rms exist and why some rms outperform othersand, more broadly, in our collective efforts to generate novel research questions and to develop a more coherent paradigmatic approach for the strategic management eld. Below we provide two examples to show the usefulness of this approach, and then proceed with discussion of a more generalized market-frictions approach. Alchian and Demsetz (1972) emphasize the issue of team production in which observation of the output is insufcient for providing rewards since the marginal productivity of each worker is unknown. Due to this nonseparability problem, ex ante free-riding (shirking) and ex post haggling can occur. Hierarchical monitoring is suggested as a solution to this problem. Within a hierarchy, one team member serves the role of monitor and receives all the residual returns, while all other team members become interchangeable employees and their inputs are undifferentiated. Rajan and Zingales (1998) build upon the nonseparability of team production and join it with the market friction of asset specicity emphasized in Williamson (1979) to develop a more general theory of power in organization. In their model, each team member makes rm-specic investments, which have little or no economic value outside the joint production. Contrary to the recommendations by property rights theory, which suggests the assignment of ownership to the team member whose rmspecic investment is most critical to the joint production (Grossman and Hart, 1986; Hart and Moore, 1990), Rajan and Zingales (1998) note that assigning ownership to that team member may reduce incentives in rm-specic investment by all team members, including the one that is assigned ownership. Rajan and Zingales (1998) proposal is to use the property rights mechanism of restricted access to critical assets, instead of ownership, for the purpose of promoting rm-specic investment and thus economic value creation. The theory by Rajan and Zingales (1998) helps to explain a variety of real-world institutional arrangements. Blair and Stout (1999) draw upon the idea of third-party ownership from Rajan and Zingales (1998) to develop a team production approach to the public corporation. The idea of third-party ownership suggests that an outsider to the actual productive activity can be granted access to the teams assets and incentivized by the
Copyright 2013 John Wiley & Sons, Ltd.

Market Frictions as Building Blocks


rich framework, Chi (1994) is able to address a series of questions, such as Under what conditions, if any, can imperfectly imitable and imperfectly mobile resources be gainfully traded across rms? What are the main difculties of trading in such resources? What mechanisms can be used to mitigate the various trading difculties and how the exchange structure between the trading parties may be affected by the adoption of those mechanisms? (1994: 272) It is also noteworthy that Chis (1994) framework considers all three strategic goals considered in the current paper: (1) the trading of strategic resources may be subject to transaction costs or problems of adverse selection, moral hazard, cheating, and economic hold-up, and thus the trading partners must design an exchange structure to minimize these costs; (2) the complementarities between resources of two rms are the value creation potential, and by trading strategic resources through a certain exchange structure, the trading partners can create economic rents; and (3) the apportionment of residual claimancy and residual control rights becomes important remedying mechanisms for the purpose of value capture. In all, a unique combination of market frictions in Chi (1994) enables a more penetrating analysis of the exchange structure in trading of strategic resources among rms than would be possible with any one theory in isolation. In terms of managerial signicance, Chi and Roehl (1997) apply this framework to explain the apportionment of residual bearing and the assignment of managerial control in exchanges of business know-how between exchange partners of international collaborative ventures. Theory development achieved by Rajan and Zingales (1998) and by Chi (1994) provides exemplar support for our thesis that by focusing on new combinations of market frictions, which serve as the unit of analysis, we can usefully gain greater explanatory power for a variety of strategic phenomena including the two primary questions of strategic management: why rms exist and why some rms outperform others.13 The preceding
13 Mahoney (2001) and Makadok (2003) tightly link the rst question of why rms exist to the second question of why some rms outperform others. Makadok states that the Mahoney (2001) conjecturethat whatever set of economic frictions is a sufcient condition for the existence of sustained economic rents will also be a sufcient condition, although perhaps not a necessary condition, for the existence of a rm. That is, the set of frictions that is required to generate the existence of a rm

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discussion suggests that the market-frictions logic informs cost minimization, value creation, and value capture. Cost minimization (utilizing market frictions primarily emphasized in transaction costs theory), value creation (utilizing market frictions primarily emphasized in the resourcebased approach and real options theory), and value capture (utilizing market frictions primarily emphasized in property rights theory) can be usefully joined by the glue of market frictions. We submit that to understand more fully either the organizational boundary question or the economic rents question, it is necessary to consider all three strategic goals. More specically, we suggest that the market-frictions logic enables us to explore the intertwined relationships between the economic rents question and the organizational boundary decision, instead of treating these two questions in isolation. Thus, we propose that by focusing on the common building blocks of different organizational economic theories, that is, the various market frictions, theories typically regarded as informing the organizational boundary question can be used to explain economic rents, and theories typically regarded as informing the economic rents question can help explain organizational boundary decisions. Greater paradigmatic development is feasible if we continue with the recent developments in organizational economics approaches that have started to incorporate multiple strategic goals and new combinations of market frictions, for the purpose of understanding both the organizational boundary question and the economic rents question. We rst show that the organizational boundary decision, which has typically been considered through a cost minimization lens (Williamson, 1985), can be further examined through a value creation and value capture lens (Dyer, 1997; Zajac and Olsen, 1993) via learning, dynamic capabilities, and knowledge spill-in from exchange partners (Hoetker, 2005; Leiblein and Miller, 2003). For example, extending the transaction as the unit of analysis to incorporate intratemporal and intertemporal spillover effects offers new insights about the organizational boundary decision. For instance, Kang et al . (2009) nd that OEM suppliers are willing to make unilateral relationshipspecic investments with buyers such as Dell,
is a subset of the set of frictions that is required to generate the existence of sustained economic rents (2003: 1045).
Strat. Mgmt. J., 34: 10191041 (2013) DOI: 10.1002/smj

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complementarities among activities (Porter, 1991), which reinforces resource (re-)bundling processes (Kor and Mahoney, 2000; Teece, 1986; Wernerfelt, 1984). More generally, the current paper suggests that a richer resource-based analysis of economic value creation will be achieved with greater attention to the intrarm spillover effects of resources in the decision calculus, and governance structure designs that can account for these potential intrarm spillover effects. Further, consideration of market frictions underpinning an organizational boundary decision enriches a theory of economic rents by addressing not only potential, but also realized value creation (Gottschlag and Zollo, 2007; Kim and Mahoney, 2002), by taking into account an appropriate governance design. The resource-based logic in Barney (1991) and Peteraf (1993) provides criteria for potential economic rents derived from resources. However, the potential economic rent of a resource is unlikely to be fully realized if property rights are under- or overdened (Ziedonis, 2004). A more systematic examination of market frictions, in general, and property rights (governance), in particular, is required to ascertain the economic value of resources (Mahoney, 2005; Makadok, 2001). Using the market-frictions logic The interrelated work of Rajan and Zingales (1998) and Blair and Stout (1999), as well as the work of Chi (1994) and Chi and Roehl (1997), are exemplars of utilizing the marketfrictions logic for development of nuanced insights and the generation of new questions. With a paradigmatic thinking based upon the marketfrictions logic, students in doctoral programs in the strategy eld are equipped with a roadmap for conducting research with an organizational economics approach. These examples also suggest that there are at least two ways that strategy research can approach their research questions using the market-friction logic. For analytical purposes, the rst approach is to start with the research gap identied within the existing literature, and the second approach is to start with the strategic phenomenon of interest. Below we briey discuss these two approaches. First, new research questions can be generated by studying the research gap in existing literature in organizational economics theories. We use Table 3 as an example to illustrate this approach.
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and suggest that OEM rms make these decisions based not only on economic benets with their current exchange partners, but also on the potential benets to be gained through established exchange relationships with these powerful buyers. If there are future (dynamic capabilities and real options) benets in forming an exchange relationship, a transaction party may choose to tolerate the risks of potential opportunistic behaviors, and make a rm boundary decision contrary to the transaction cost economic (cost-minimization) prediction based on the single transaction as the unit of analysis. Qian, Agarwal, and Hoetker (2012) also emphasize intertemporal spillover effects in the context of industry evolution, where industry entrants design their rm boundary by taking into account the entry timing or the different industry evolution stages. In particular, this study nds that rms entering later to an industry are less likely to internalize transactions than those entering earlier, suggesting that some transaction costs are enduring while some other transaction costs are transient. Not only will potential value-creation considerations inuence the organizational boundary decision, but potential value destruction will also impact this decision. For example, Argyres and Liebeskind (1999) emphasize that past (sunk cost) commitment to a specic transaction partner may become an important path-dependent factor in the current organizational boundary decisions. Focusing on the single transaction as the unit of analysis may neglect potentially important intrarm spillover effects that can occur across multiple transactions (Argyres and Liebeskind, 2002). Attempting to separate two interdependent boundary decisions may cause a loss in economic value. Moreover, the strategic management elds predictive power for the economic rents question can be improved when market frictions related to organizational boundary choice are considered. A more complete theory of economic rents needs to incorporate (interdivisional and intertemporal) spillover effects. Utilizing the individual resource as the unit of analysis will have limitations since it may neglect important intrarm spillover costs and benets to the bundle of resources that the decision maker either currently possesses or may possess over time (Penrose, 1959). For instance, research on activity systems (Kauffman, 1993; Milgrom and Roberts, 1990) suggests an important unit of analysis for developing a theory of economic rents. An activity system approach emphasizes
Copyright 2013 John Wiley & Sons, Ltd.

Market Frictions as Building Blocks


Table 3. Exemplar studies joining multiple organizational economics theories Insights gained from joining the market frictions emphasized by the respective theories

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Original theory pairings

Exemplar studies

Sample of new questions generated by incorporating other market frictions typically not emphasized by those theory pairings

Transaction costs Hennart (1988) theory and property rights theory

Transaction costs theory and Resource-based approach Transaction costs theory and real options theory

Silverman (1999)

Folta (1998)

Property rights theory Luo (2002) and resource-based approach

Property rights theory Miller and Folta and real options (2002)

Resource-based approach and real options

Kogut and Kulatilaka (2001)

The choice of equity JV Scale joint ventures (JVs): when inuences exibility of each parents seek to internalize a failing parent rm involved, as well market, but indivisibilities due to scale or scope economies make full as interparent rm spillovers. How might consideration of ownership of the relevant assets these inuences impact the inefcient. governance choice of JV Link JVs: simultaneous failing of types from the beginning? markets for services of two or more assets as rm-specic public goods, and acquisition of the rm holding them incurs signicant management costs. Consider also the real options Rent-generating resources are implications of decision considered to have high asset making under uncertainty specicity, and thus are less likely from two alternative modes: to be utilized in contractual licensing and diversication. alternatives (e.g., licensing) than through diversication. How would arrangement of the Technological uncertainty plays an residual claimancy and important role in the preference for residual control rights equity collaboration (over embedded in the two modes acquisition) in domains of higher (equity collaboration and asset specicity. acquisition) affect the role of technological uncertainty? Consider the role of the While capability exploitation is property-rights regime associated with the use of wholly (whether there is owned entry mode, capability well-dened or poorly building is linked to the joint dened property rights venture mode. MNEs seeking local protection) in the MNEs market expansion also deploy entry mode choice and its greater capability exploitation and implications on performance. building than those seeking export market growth (p. 48). How would a rms Optimal timing for exercising real path-dependent capability options depends on current development change the dividends, possibilities for preemption, and whether the option attributes (possibilities of preemption; proprietary) of a is simple or compound, proprietary real option? or shared (p. 655). What are the roles of Managers cannot easily adjust the governance inseparability wrong set of organizational (Argyres and Liebeskind, capabilities to the emergence of 1999) and intertemporal market opportunities . . . rms that spillovers in strengthening have made investments in the irreversibility of capabilities appropriate to these organizational capabilities, opportunities are able to respond and further impacting the (p. 744). heuristics of managers in making capability investment decisions?

Copyright 2013 John Wiley & Sons, Ltd.

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applied to a wide range of strategic phenomena, such as competitive advantage, diversication, and divestment, and the scope of the rm (e.g., alliance, joint venture, and M&A) (Capron, Duassauge, and Mitchell, 1998; Ramanujam and Varadarajan, 1989). Identifying and selecting the market frictions most relevant to a particular managerial problem, however, requires careful evaluation of which goal is most relevant for the problem at hand. Some market-frictions problems require managers to primarily attend to cost minimization, while other problems may require greater attention to value creation and capture. Having identied the priorities of different strategic goals concerned in the strategic problems or phenomena, a strategy scholar proceeds by selecting a combination of relevant market frictions underpinning those strategic goals. A more challenging next step is to examine the interrelationships among these identied market frictions, and to tease out potentially different or overlapping driving forces for each market friction. For instance, measurement cost may lead to asymmetric information, and can also cause difculty in delineating property rights with greater precision. Having chosen the primary market frictions and having analyzed the interrelationships among them, the nal step of theory development is to consider additional market frictions that may be relevant to the focal problems or phenomena but are less emphasized in existing research literature, as we have suggested in Table 2. Incorporating these market frictions is likely to produce novel insights. Two research streams can illustrate the usefulness of this approach. Consider rst strategic outsourcing. To examine this phenomenon with our market-frictions logic, we can start by asking questions like: What market frictions are involved in a strategic outsourcing decision? How can these market frictions be recombined to better explain this organizational boundary question? On the one hand, prevailing information technologies reduce (1) information asymmetry and search costs, (2) nonseparability problems in team production, and (3) asset specicity (small-numbers) problems due to increased connectivity, which mitigate market frictions (Lajili and Mahoney, 2006). On the other hand, outsourcing a business function to another rm involves knowledge transfer and potentially involuntary knowledge spillovers, which requires appropriate property rights allocation. Thus, a practice of recombining market frictions can prove
Strat. Mgmt. J., 34: 10191041 (2013) DOI: 10.1002/smj

Column 1 in Table 3 lists six potential pairs of two organizational economics theories; Column 2 presents exemplar research of the pairwise joining of the corresponding theories; Column 3 provides insights gained from joining market frictions emphasized by the respective theories; and Column 4 suggests new questions that can be raised by incorporating other market frictions that are typically not emphasized by those theory pairings. For a thought exercise, consider Silverman (1999), which examines the diversication choice through industry entry versus other contractual modes (e.g., licensing) for rms that intend to exploit their technological resources. Technological resources with strong applicability to a different industry provide potential economic value creation through exploiting those resources in that industry. However, the extent of realized value creation through exploitation is subject to the difculty in appropriating returns to innovation, or the appropriability regime of a given industry. Accordingly, Silverman (1999) predicts that if the target industry is characterized by high secrecy, a high learning curve, or low feasibility of using licensing, contractual hazards will be high, and diversication will be a preferred method for exploiting a technological resource. Based upon these predictions, there are many other questions a reader can probe further. For instance, what other market friction aspects of the choice between industry entry and contractual licensing may impact the choice itself? Industry entry through diversication provides stronger economic safeguards for appropriation of returns to innovation, but also requires stronger resource commitment or possible sunk costs than other contractual methods. In addition, exploiting existing technological resources through diversication may prevent the focal rm from exploring new resources and new knowledge that can be potentially spilled in if cooperative modes with other partner rms were chosen. By raising such questions, we can gain a better understanding of the boundary conditions for research ndings from Silverman (1999) and, more importantly, generate new research questions. Similar thought exercises can be carried out for all the other papers included in Table 3. The second approach starts with the strategic phenomena of research interest. Because the market-frictions logic outlined in this paper attends to all three strategic goals of strategy, it can be
Copyright 2013 John Wiley & Sons, Ltd.

Market Frictions as Building Blocks


useful in examining strategic outsourcing. A second research stream concerns employee mobility and entrepreneurship. Considered as agents for creative construction (Agarwal, Audretsch, and Sakar, 2007), employee entrepreneurs can leverage the underutilized knowledge of the parent rms and channel knowledge spillovers to venture creation. Here the market frictions both within and beyond the parent rms play important roles in employee mobility, in that information asymmetry and knowledge spillovers spur value-creation opportunities for those employees who break away from the existing rm boundary. While strategic outsourcing attends to the cost minimization goal, the employee mobility phenomenon focuses on economic value creation. It is clear that whether a strategic phenomenon points to vertical integration or deintegration (e.g., new venture creation or outsourcing), the organizational economics principle of examining market frictions remains durable across these phenomena.

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CONCLUSIONS
This paper both takes stock and looks ahead concerning the role of market frictions as building blocks of an organizational economics approach to strategic management. We take stock of this research literature (i.e., transaction costs, property rights, real options, and resource-based approaches) to identify an evolving paradigmatic approach that has taken place over the past quarter century. We illustrate the rich connections among these theories via market frictions, and we show the usefulness of combining market frictions from various theories in novel ways. We then apply the market-frictions logic to organizational boundary and economic rents questions to show how joining cost minimization, value creation, and value capture can be achieved through considering various market frictions. More generally, we maintain that it is useful to view market frictions as the fundamental building blocks of strategic management, and the analysis of new combinations of market frictions may provide new strategic insights. Recombinations of market frictions can be achieved by joining various organizational economics theories, but that is not the only path to gaining such insights since these theories typically emphasize a particular cluster of market frictions. Instead of focusing
Copyright 2013 John Wiley & Sons, Ltd.

exclusively on joining different molecules (i.e., the different organizational economics theories), we can fruitfully join various atoms (i.e., the market frictions themselves). Joining theories per se is likely to restrict the choice set of possible combinations of market frictions. Thinking in terms of the primitives of these market frictions themselves can open the theory space for new strategic insights to emerge. Developing the market-frictions logic is also promising for providing key managerial implications. Managersalong with researcherscan proactively consider market frictions that enable cost minimization and the generation of rm-level economic rents. For example, managers have the opportunity to provide economic value in business situations where market frictions exist and price signals are not sufcient. Thus, the managerial calculus should include the intrarm spillover benets and costs that are not typically priced in standard discounted cash ow formulations. Such strategic connections show that the marketfrictions logic enables us to better join theory with management practice. Indeed, Yao (1988) suggests that both practitioners and researchers will obtain more penetrating insights from considering fundamental market frictions than the relatively less precise (i.e., more aggregated) concepts of entry and mobility barriers that strategic management borrowed from industrial organization economics (Porter, 1991). Finally, we note that while transaction costs theory was relatively well developed at the time of Yaos (1988) seminal paper, the strategic management eld has since developed the resourcebased and real options approaches, and has begun to make progress in utilizing property rights theory. In an important sense, the current paper has attempted to reconstruct the elds theory development in the past two decades from a marketfrictions lens to show the evolving paradigmatic development that has occurred over time. Indeed, designing operational solutions to attenuate market frictions to minimize costs or to leverage market frictions for the purpose of value creation and value capture is at the core of the economic foundations of strategy. It is anticipated that a more systematic examination of market frictions for further exploration of the organizational boundary decision, the sustainability of rm-level economic rents, and other strategic issues will enable the next
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generation of research within our evolving strategic management eld to do even better.

ACKNOWLEDGEMENTS
We thank Rajshree Agarwal, Nick Argyres, Janet Bercovitz, Daniel Elfenbein, Jovan Grahovac, Glenn Hoetker, Yasemin Kor, Steve Michael, Doug Miller, Jackson Nickerson, Deepak Somaya, and Todd Zenger for useful comments and suggestions. We also thank Rich Bettis and the anonymous reviewers for their counsel, which helped improve the paper signicantly. The process of writing this paper reinforces the view that the virtues of an argument depend upon the virtues of its audience. Finally, we thank participants at research seminars at the University of Illinois at Urbana-Champaign and at Washington University in St. Louis. We also thank participants at the October 2009 Strategic Management Society (SMS) meeting in Washington, DC. The usual disclaimer applies.

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